Ben Graham Formula: Empirical Evidence [ANALYSIS]

Editor’s note: Ben Graham Formula some great data. The presentation comes from an occasional contributor to the website. It explains the methodology used for his value fund. Whether you are interested in the fund or not, the data and article is EXTREMELY interesting.

Ben Graham Formula – By Steven De Klerck

Slide 1: This presentation will explain the investment principles of the CAPITA Global Quant Value Fund. In a first step we will develop the necessary knowledge. Knowledge is the perfect counterbalance for the return-destroying emotions that often creep into our investment decisions. Next we will apply this knowledge with the development of the value strategy within the CAPITA Global Quant Value Fund. Finally we pay attention to the psychological pitfalls.

Slide 2: The presentation consists of six parts. In a first part we refer to the founding father of fundamental quantitative analysis and value investing: Benjamin Graham. In a second and third part we discuss the historical results of quantitative value investing with a focus on financial safety. Subsequently the acquired knowledge is transformed step by step in the investment strategy used within the CAPITA Global Quant Value Fund. We will observe that successful value investing technically is simple. “Investing is simple, but not easy”, Warren Buffett appropriately quoted. With regard to the “not easy” part, as investors, we often are confronted with emotions (doubt, fear, panic, greed,…), notably in periods of inferior and/or negative returns. In the last part but one we pay attention to the way in which Benjamin Graham advised investors to deal with these emotions. In a final part we discuss the conclusions.

Slide 3: Ben Graham’s investment philosophy

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Slide 4: We start with a concise retrospective of Benjamin Graham’s investment philosophy. With Security Analysis(1934) and The Intelligent Investor (1949) Graham laid the foundations of quantitative value investing. Security Analysiswas written at the time of The Great Depression. In this book Graham looks back over this for investors extremely difficult period; in nominal terms the Dow Jones dropped no less than 90%. Graham, amongst other things, comments upon the mistakes which investors over the period 1925-1929 fell victim to. Graham was also Warren Buffett’s professor at Columbia University. Warren Buffett described The Intelligent Investor as “By far the best book on investing ever written.”

Slide 5: Successful investing, as Graham concludes in The Intelligent Investor, requires the combination of both an adequate safety margin for each stock on the one hand and a wide diversification of risk on the other.

Slide 6: An adequate safety margin for a stock is looked after by focusing on the so-called “intrinsic value factors”. This implies the focus on fundamental quantitative elements such as “earnings, dividends, assets and capital structure”. Based on these accounting numbers valuations (e.g. a price-to-earnings ratio) and other financial ratios (e.g. solvency) can be calculated. All too often investors use speculative, subjective elements as input to investment decisions.

Slide 7: With speculative elements Graham means the “intangible value factors” such as the assessment of management and forecasts of future pay-offs. Such “intangible value factors” are not objectively quantifiable; the valuation of these factors is extremely subjective and fluctuates widely with the optimism and pessimism on the stock market. In Security Analysis (1934) Graham refers for example to The Roaring Twenties or The New Era; from 1925 through 1929 the valuation of the US stock market substantially surpassed the historical average. More and more investors paid attention to future earnings expectations, expectations that invariably were raised in order to account for the absurd valuations.

In 1949 Benjamin Graham concluded that the fundamental quantitative approach has realized attractive returns in the past. In the next part of this presentation we will see that this quantitative approach also has evidently realized strong returns in the decades after 1949.

Slide 8: Empirical evidence – Part 1

Slide 9: We begin with the academic – and at the same time very simple – definition of a value stock and a growth stock. A value stock is defined as a stock with a (relatively) low price-to-book, price-to-sales, price-to-earnings and/or price-to-cash flow ratio (or possibly other indicators such as for example the enterprise value-ebit ratio). Companies with a price-to-book ratio smaller than 1, a price-to-sales ratio smaller than 0.75 and/or a price-to-earnings ratio smaller than 10 usually are considered to be value stocks. A growth stock is defined as a stock with a (relatively) high price-to-book, price-to-sales, price-to-earnings and/or price-to-cash flow ratio. Companies with a price-to-book ratio larger than 3, a price-to-sales ratio larger than 2 and/or a price-to-earnings ratio larger than 25 usually are considered to be growth stocks.

Slide 10: Numerous studies have documented the historical returns of value stocks versus those of growth stocks, both in developed markets, emerging markets and in frontier markets. One of these studies was published in 2004 by Chan & Lakonishok. In this study the largest US companies, in terms of market capitalization, are divided in ten stock portfolios. The first portfolio, the value portfolio, contains the stocks with the lowest valuation in terms of price-to-book, price-to-sales, price-to-earnings and price-to-cash flow. The tenth stock portfolio, the growth portfolio, includes the stocks with the highest valuation in terms of price-to-book, price-to-sales, price-to-earnings and price-to-cash flow. Each year stock portfolios are established based on these valuation measures. Subsequently Chan & Lakonishok (2004) document the returns of these ten stock portfolios over the 1969-2000 period. What is to be concluded? The value portfolio realizes a compound annual return of 15.6%; the growth portfolio realizes a return of only 6.2%.

Slide 11: The study by Chan & Lakonishok (2004) runs out in 2000. We have implemented this study over the 1969-2013 period. Again we note a return of 15.2% for value stocks. For growth stocks we document a compound annual return of only 8.4%. We would like to highlight the simplicity of this investment strategy. Four simple valuation measures. A pure focus on objective, quantifiable criteria. No subjective, qualitative inputs. No forecasts.

Slide 12: What explains the higher historical returns of value stocks? The veil was already raised when discussing Ben Graham’s investment philosophy, in the beginning of this presentation. Graham warns investors to introduce as less as possible subjective elements, such as future earnings expectations, when taking investment decisions. The subjective elements, as Graham literally posed, “are not susceptible to mathematical calculation”. The introduction of “intangible value factors” results in overoptimistic growth expectations, in particular for growth stocks and promising companies. This viewpoint was confirmed by Skinner & Sloan (2002). Skinner & Sloan (2002) in a nutshell show that growth stocks, following the publication of disappointing results, are punished much worse than value stocks. In case of results which are in accordance with or exceed expectations there is no significant difference between the returns of value stocks and growth stocks. The findings of Skinner & Sloan (2002) perfectly match the vision of Graham in The Intelligent Investor (1949):

What seems to happen, rather, is that the price remains high until the earnings actually show a definite falling off – which invariably seems to take the followers of the issue by surprise. Then we have the market decline usually associated with a disappointing development – a decline perhaps intensified by the fact that the price level of the growth stock had been dangerously high.

Slide 13: Based on the numerous studies we are able to conclude that, compared to growth stocks, value stocks in the long term realize a significantly higher return.

Slide 14: Empirical evidence – Part 2

Slide 15: Some academics argued ex post that value stocks realize a higher return because they have a higher, undefinable risk. In this view we would like to point to the inadequate academic definition of a value stock. As already mentioned above, it is understood that apart from the valuation Graham also took into account the financial strength (“capital structure”) prior to considering a stock to be a value stock.

Slide 16: Within a value portfolio various studies have distinguished between companies with a strong and weak financial position. In this field we have the well-known study by Piotroski (2000). This researcher shows that within a value portfolio companies with the weakest business economic fundamentals realize a significantly lower stock return. In the fundamental, quantitative tradition of Graham & Dodd (1934) a company’s business economic position is assessed based on profitability, solvency and liquidity.

Slide 17: Similar results are documented by Campbell et al. (2008), among many other studies (Haugen, 2002). These researchers show that preferably value investors remove companies with the weakest business economic fundamentals from their stock portfolio. An example of a company with a weak business economic position is a company being confronted with subsequent substantial losses, a very high debt load and/or an inferior liquidity position. Once again these criteria can be quantified in an objective way. It is possible to measure profitability based on, for example, the return on total assets. It is possible to assess solvency based on total financial debt to common equity. Liquidity for example is measured based on total cash to enterprise value.

Slide 18: Up to now we have gathered quite some knowledge. We learned that Ben Graham mainly paid attention to objective, quantifiable fundamentals computed using the historical financial statements. Next we have discussed the academic definition of a value stock and a growth stock. We documented the higher historical returns to value stocks and we explained the underlying reason. Finally we have observed that by no means value investors should buy junk companies. Intelligent value investors are right to increase the “margin of safety” of their stock portfolio by removing companies with an inferior profitability, solvency and/or liquidity.

Slide 19: Based on the accumulated knowledge now we are able to discuss the investment strategy of the CAPITA Global Quant Value Fund and to fully understand the choices made.

Slide 20: The investment strategy of the CAPITA Global Quant Value Fund is built on four pillars: value, financial safety, diversification and liquidity. The investment strategy is implemented in three steps.

Slide 21: In a first step the current valuation of all countries, which in all are 32 developed and emerging markets, is assessed from a historical perspective. Benjamin Graham invariably advised not to buy shares when the current valuation of the stock market, using traditional valuation measures such as the price-to-book ratio, is significantly above the historical average. Numerous studies indeed show that value countries realize a significant higher future return compared to growth countries.

Slide 22: The slide shows the international stock market valuations start January 2014. When current valuations are above the 80th percentile (in less than 20% of all historical instances this stock market was cheaper in the past) no stock positions for that particular country will be taken within the CAPITA Global Quant Value Fund. In this view we can see that in early January 2014 the valuation of some emerging markets in Asia (Indonesia, Philippines and Thailand) is significantly above their historical average.

Slide 23: In a second step, with regard to the countries still selected, the companies having a market cap too small (< €250 Million) or a daily liquidity which is too restricted (< €500k) or a very weak business economic position in terms of profitability, solvency and liquidity or having a valuation which is too high (e.g. price-to-book ratio >> 3) are removed. In this way we eliminate all companies with the weakest fundamentals, in line with the important lesson from the studies mentioned above.

Slide 24: In a final step we are looking for the global stock portfolio consisting of some 40 stocks with the strongest value tilt, this means the lowest combined valuation in terms of price-to-book and enterprise value-ebit, amongst other valuation measures. It is understood that here we also take into account the necessary diversification and we make sure that for the stock portfolio the ratio of common equity to total assets (“financial safety”) is always set to 60%.

Slide 25-28: On these slides we see the result of this strategy for December 2013. We obtain a diversified global stock portfolio, consisting of about 40 profitable companies, that is cheap (e.g. price-to-book = 0.82; enterprise value-ebit = 5.57), disposes of a solid business economic position (e.g. common equity-total assets = 60%; total debt-common equity = 33%; cash-total assets = 11%) and characterized by global and industry diversification. In this way we get a stock portfolio which is perfectly in line with the principles of Benjamin Graham:

Investment can be grounded largely on the time-tested principle of insurance – which combines an adequate safety factor in each individual commitment with a wide diversification of risk.

The valuation and financial characteristics mentioned invariably will be clearly communicated by the CAPITA Global Quant Value Fund. The importance of this transparent communication will become obvious when discussing the psychological pitfalls of value investing.

Slide 29: When the strategy is consistently implemented over the 1996-2013 period with annual rebalancing we obtain the results on the slide: a financially safe value strategy in non-overvalued stock markets. Over the period taken into account this “margin of safety” strategy realizes a compound annual return of about 16.2% (already taking into account a burden of costs of +1% on an annual basis), which is in line with the empirical results discussed above. It is understood that periods of strong returns are alternated with periods suffering from inferior returns. The strategy has already been used since January 2011, the results are marked with the dark blue bars.

Slide 30: In the final part of this presentation we discuss the psychological pitfalls. Benjamin Graham correctly argued that “Intelligent investing is more a matter of mental approach than it is of technique.” Warren Buffett phrased this vision as follows: “Investing is simple, but not easy”. In the previous parts indeed we have noticed that successful value investing is no “rocket science”. In this final part we will see that for many (professional) investors the practice of value investing however is “not easy”.

Slide 31: Investors experience at least two difficulties when implementing value strategies: on the one hand the problem of inferior returns; on the other the confrontation with stock market periods characterized by negative returns for value stocks. For many investors the psychological pressure becomes too strong when in the short term value strategies realize both inferior and negative returns.

Slide 32-33: The first slide shows the real return to value and growth investing over two-year periods in line with the strategy by Chan & Lakonishok (2004). The second slide documents the real return over ten-year periods. We observe that over ten-year periods value stocks invariably realize a higher return, with the exception of one ten-year period: the period of the Internet bubble. In the short term (a two-year period is the short term) we note however that value stocks sometimes realize a return that is significantly lower than the return of growth stocks. In the two years up to 1972 we note for example that value stocks realize a return of 46%; growth stocks outperform with a return of almost 80%. It becomes even worse for value stocks concerning the two stock market years up to 1973: a significantly negative return for value stocks; a zero return for growth stocks. The majority of investors starts to be unsure; many investors already give up. And it becomes even worse in for example the Internet period. Value stocks realize a negative return; growth stocks blow the limit with a return of +50%. The overwhelming majority of investors gives in and switches to growth stocks and promising companies, of course at the wrong moment. “Investing is simple, but not easy.”

Slide 34: An issue in this field of which few investors are aware is the finding that stock prices are much more volatile than their underlying intrinsic values (an intrinsic value that can only be determined ex post). The red line on the graph shows the real price of the S&P500; the black line indicates the ex post calculated intrinsic value. We note that stock prices are 19 times more volatile than the underlying intrinsic value. Both John Maynard Keynes and Benjamin Graham realized the problem for many investors. The uncertainty associated with the excessive stock price fluctuations creates doubts in the mind of investors, resulting in many emotions (frustrations, greed, panic, regret,…) and inferior investment decisions. “Common stocks can be dynamite.”

Slide 35-36: Benjamin Graham consequently advised to invariably focus on the objective quantifiable fundamentals, as indicated by the four pillars of the CAPITA Global Quant Value Fund. Without any doubt the following perception is one of the most important insights of Graham from The Intelligent Investor (1949):

He, the investor, must deal in values, not in price movements. He must be relatively immune to optimism or pessimism and impervious to business or stock-market forecasts. In a word, he must be psychologically prepared to be a true investor and not a speculator masquerading as an investor. If he can meet this test, he will be a member not of the public at large but of a specialized and self-disciplined group.

Now it becomes clear why – within the CAPITA Global Quant Value Fund – we highlight the fundamental characteristics mentioned (price-to-book, enterprise value-ebit, common equity-total assets, total financial debt-common equity, cash-total assets,…). These fundamental criteria create the “margin of safety” and provide investors with attractive stock returns, not the subjective, emotional elements such as future earnings forecasts. In challenging periods, such as the Internet period and the 2008-2009 period, a true value investor invariably can fall back on these objective fundamentals. In the Internet period the value investor actually considers the valuation of his stock portfolio (“value”). He holds a cheap and solid stock portfolio and consequently there is no reason to change to significantly overvalued growth stocks. In extremely weak periods such as 2008-2009 the value investor mainly focuses on the financial safety of his stock portfolio. With a diversified stock portfolio consisting of profitable companies, common equity to total assets of at least 60%, few financial debts and a solid liquidity position, the value investor makes sure his stock portfolio can survive a crisis like that of 2008-2009. Based on this way of thinking (“mental approach”) the true value investor make sure that:

he will be a member not of the public at large but of a specialized and self-disciplined group.

Based on this transparent way of communication focusing on quantitative fundamentals, in line with the investment philosophy of Benjamin Graham, within the CAPITA Global Quant Value Fund we also find a solution for a common phenomenon where investors massively join in AFTER a period of strong returns and massively run for the exits AFTERweaker fund returns. In this view, in his book The Big Secret for The Small Investor Joel Greenblatt (2011) states that the best performing US mutual fund realizes a compound annual return of 18% over the 2000-2009 period. The average investor in this fund realizes a compound annual return of … -11%! Time and again the average investor joined in after some years of strong performance; subsequently the average investor ran for the exits after a period characterized by weak returns. In other words investors relied on “price movements” (refer to the quote mentioned before), not on “values”, and hence they invariably bought at high prices and sold at low prices.

An investor scrupulously following Benjamin Graham’s advice mainly focuses on the valuations (“value”) in the upper left corner. In case of a decrease in the valuations of the value portfolio of the CAPITA Global Quant Value Fund (e.g. a price-to-book ratio going down from 0.82 to 0.65) the value investor can find bargains. Conversely the advance of the valuations compels the value investor to some reserve. In this way we find that for a true value investor following Graham’s advice and focusing on objective, quantifiable fundamentals, the chances to make the common “buy high, sell low” mistake becomes much smaller. “Investing is simple” and in this way at the same time it becomes quite “easier”.

Slide 37-38: Conclusions. Already in 1949 Benjamin Graham had a lot of confidence in the fundamental quantitative approach. From experience Graham learned that this approach with focus on fundamental safety and diversification results in attractive returns in the long term. Graham’s fundamental quantitative approach was carried on by Warren Buffett, who in 1994 concluded that:

Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.

No doubt we have seen that quantitative value investing is no “rocket science”. Establishing a diversified stock portfolio which is cheap on the one hand and has a sufficiently strong business economic position on the other, is all that matters. “Margin of safety” combined with “diversification”.

Slide 39: The diversified and financially safe value strategy of the CAPITA Global Quant Value Fund soon will be open for investors at extremely attractive conditions. Investors in the fund pay no management fee. A performance fee is to be paid uniquely following the realization of consistently strong performances. For an annual return below 6% the investor pays no fee at all. For the annual return higher than 6% CAPITA Asset Management will receive 25% of this return. It should be noted that here a “High Water Mark” is being used. Moreover the partners commit themselves to re-invest all performance fees in the fund, which highlights our confidence in the strategy. The cost structure is estimated at 50 basis points. The application of the strategy on a private account soon results in a total cost of 185 basis point (25% taxes on dividends, 0.25% transaction tax, transaction fees and custody fees). Finally the shares in the fund will not be lend out to other parties as part of a “Securities Lending” program. The shares are safely stored by the custodian (UBS).

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